Pengyuan International Assigns 'A' Rating to China Baowu Steel Group

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Pengyuan International Assigns ‘A’ Rating to China Baowu Steel Group; Outlook Stable

Ratings Overview

Issuer Rating ▪ Pengyuan International has assigned a first-time global scale long-term issuer LT Issuer Credit Rating A credit rating (LTICR) of ‘A’ to China Baowu Steel Group Limited (Baowu). The outlook is stable. Outlook Stable ▪ Baowu’s issuer credit rating is based on a ‘bbb-’ standalone credit profile

(SACP) and our assessment that the central government has very strong willingness to support the Company in the event of a financial distress.

▪ The stand-alone credit profile (SACP) of Baowu is supported by its leading Contents market position and large operating scale in global steel industry, and is constrained by its relatively high leverage and shrinking profit margins caused Key Rating Drivers ...... 2 by the overcapacity and weakening demand of steel product in the long run. Business Profile ...... 3 Rating Outlook Financial Profile ...... 5 Government Support ...... 6 ▪ The stable outlook reflects our expectation that Baowu will be able to maintain its operation amid the recovery of China’s economy and the Chinese central Liquidity...... 6 government will continue to support the Company in the event of distress. Company Background ...... 6 ▪ We would consider a rating downgrade if 1) substantial evidence shows that Peer comparison ...... 7 the central government’s willingness to support the Company weakens in the event of distress; 2) we downgrade our sovereign credit rating on China. Rating Scores Summary ...... 8 ▪ We would consider a rating upgrade if 1) there is further backing from the Related Criteria ...... 8 government to support the Company; 2) we upgrade our sovereign credit rating on China.

Financial Summary

Table 1: Financial Ratios 2018A 2019A 2020F 2021F 2022F Contacts Debt/EBITDA 1.8x 2.7x 3.3x 2.7x 2.5x EBITDA Interest Coverage 8.1x 6.5x 6.6x 7.1x 7.4x Primary Analyst Gross Debt/Capitalisation 34.2% 34.4% 37.7% 36.2% 34.6% FFO/Debt 48.6% 32.1% 23.1% 28.4% 30.6% Name Winnie Guo OCF/Debt 39.4% 10.6% 2.5% 21.7% 12.2% Title Director Direct +852 3615 8344 FCF/Debt 24.7% -12.1% -16.3% 0.9% -2.5% Email [email protected] EBITDA Margin 15.9% 10.8% 10.5% 11.3% 11.0%

Secondary Analyst ROIC 15.5% 12.3% 9.2% 9.6% 9.5% Source: Company, Pengyuan International estimates Name Leon Li Title Analyst Direct +86 755 2348 3867 Email [email protected]

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Key Rating Drivers

Credit Strengths Strong external support from the SASAC. Baowu is 90% held by the State-owned Assets Supervision and Administration Commission of the State Council (SASAC). The Chinese government controls the board and senior management appointment. Hence, the Chinese government has a strong influence over Baowu’s long-term strategies. Baowu has taken the lead in restructuring China’s steel industry and implemented the supply-side reforms as instructed by the government. A number of Baowu’s mergers and acquisitions of China’s steel industry players were done through stake transfers approved by the SASAC, demonstrating the government’s support to the Company. The Company has successfully acquired Magang Group (Magang) in 2019 and Taiyuan Iron & Steel Group (TISCO) in 2020.

Global leader in steel production industry. After consolidating with TISCO, Baowu became the largest steel producer in the world in terms of crude steel production. The Company was ranked 111th by Fortune on the Top500 list. Baowu reported 95 million tonnes of crude steel production in 2019. Its crude steel production capacity will reach over 100 million tonnes after its takeover of TISCO. Benefiting from the acquisitions and consolidations, Baowu will be able to increase its market shares, strengthen its bargaining power and enlarge its economies of scale.

Dominant position in steel market. Owning dominant market shares in the subdivided steel markets, Baowu is the largest and the third largest provider in silicon steel and auto-sheet in the world, measured by the sales volume. The Company has a diversified product line, specialising in producing high quality and high value-added steel products. The acquisitions of Magang and TISCO have enabled the Company to further enhance its market position in wheel tire, H-shaped steel products and stainless-steel products. Benefiting from its market position and strong technical expertise, the Company has established long-term strategic relationship with its customers, most of whom are industry leaders in different manufacturing sectors in China.

Financial profile to improve. We expect Baowu to lower its leverage in 2021 and 2022, driven by a solid growth in EBITDA and disciplined capital expenditure. Steel prices have picked up since May 2020, driven by the revival of industrial production in China. We expect China's steel demand to further pick up in 2021 amid favourable government policies towards the downstream industries such as construction, infrastructure and automobile. As a result, we expect Baowu to maintain an around 10% EBITDA margin in 2021 and 2022. In addition, we expect the Company’s adjusted debt to decline on a medium- term normalised capital expenditure basis.

Credit Weaknesses

Business concentration risk. Despite a diversified product portfolio, Baowu has a majority of its revenue generated from the steel industry. As a result, the Company’s profitability has a high exposure to the cyclicality and the risk of the steel industry.

Risk associated with mergers and acquisitions. Baowu has been active in the mergers and acquisitions in the recent years. Though we see opportunities and benefits, the mergers and acquisitions increased the operating risks, as synergies generated may not be as significant as the Company has expected.

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Table 2: Key Credit Metrics (RMB million) 2018A 2019A 2020F 2021F 2022F Financials and Profitability Revenue 530,019 552,206 649,454 692,837 730,948 EBITDA 84,306 59,430 68,254 78,296 80,164 EBITDA margin 15.9% 10.8% 10.5% 11.3% 11.0% Return on assets (ROA) 6.4% 5.2% 4.5% 4.9% 4.9% Return on invested capital (ROIC) 15.5% 12.3% 9.2% 9.6% 9.5% Cash Flow Measures Funds from operations (FFO) 74,365 52,082 52,658 60,388 62,205 Operating cash flows (OCF) 60,334 17,232 5,711 46,198 24,867 Free cash flow (FCF) 37,758 -19,628 -37,186 2,016 -5,026 Discretionary cash flow (DCF) 29,422 -27,303 -43,521 -5,489 -12,324 Capital expenditure 22,576 36,861 42,897 44,182 29,893 Balance Sheet Measures Cash and liquid investments 83,336 108,173 128,311 141,715 149,606 Excess cash 50,409 55,693 70,366 82,699 89,529 Total debt 203,374 218,137 298,546 295,546 292,546 Adjusted debt 152,965 162,444 228,180 212,847 203,017 Total capitalization 594,566 633,529 791,213 817,076 845,010 Leverage Measures Debt/EBITDA 1.8x 2.7x 3.3x 2.7x 2.5x EBITDA/Interest expense 8.1x 6.5x 6.6x 7.2x 7.4x Gross debt/Capitalization 34.2% 34.4% 37.7% 36.2% 34.6% OCF/Debt 39.4% 10.6% 2.5% 21.7% 12.2% FCF/Debt 24.7% -12.1% -16.3% 0.9% -2.5% FFO/Debt 48.6% 32.1% 23.1% 28.4% 30.6% DCF/Debt 19.2% -16.8% -19.1% -2.6% -6.1% Debt/Equity 39.1% 39.1% 46.3% 40.8% 36.7% FFO/Cash interest expense 7.1x 6.9x 5.1x 5.5x 5.8x * EBITDA and EBITDA margin include cash dividends from equity investment Source: Company, Pengyuan International estimates Business Profile

Global leader in steel production industry

Baowu was formed through the merger between Baosteel and Wuhan Iron & Steel in 2016. Since then, Baowu has become the largest in China and the second largest steel production company worldwide, in terms of crude steel production. In 2019, Baowu registered 95.47 million tonnes of crude steel production and RMB552.2 billion of revenue. The Company was ranked 111th by Fortune on the Top500 list.

In recent years, Baowu has implemented the supply-side reform, running in line with the government’s policy. The Company targets to become a global steel leader with an annual output of 100 million tonnes in the medium term. Baowu’s acquisition of Magang Group Holding Co. in June 2019 is expected to strengthen the Company’s steel production, boosting its output to more than 90 million tonnes. In September 2020, the SASAC of the State Council approved the acquisition of a 51 percent stake in TISCO by Baowu through stake transfer from Shanxi Province State-owned Capital Operation Co., Ltd. Taking into account of TISCO’s 10.86 million tonnes of crude steel production in 2019, the consolidated Baowu crude steel production in 2020 is estimated to reach over 100 million tonnes, outpacing the world’s largest steel-maker ArcelorMittal with 97.31 million tonnes of crude steel production in 2019.

An industry-wide restructuring is taking place in China, in anticipation of more merger and acquisition activity to continue at an active pace over the next three to five years. By 2025, the country's top 10 steel enterprises will raise their output to between 60% and 70% of the nation's total, according to the target set by the State Council. In this case, we believe Baowu, a leading steel producer in China, will continue its business expansion via mergers and acquisitions in the next three to five years.

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Exhibit 1: Baowu’s crude steel production and capacity utilization reaches a record level

120 in million tonnes 100%

100 95%

80 90%

60 85%

40 80%

20 75%

0 70% 2016 2017 2018 2019

Production capacity Prodduction Rate of capacity utilization (RHS)

Source: Company, Pengyuan International estimates

Majority of its revenue generated from the steel business

Baowu has a relatively diversified product portfolio despite the fact that its revenue generation is very concentrated geographically in China and industrially in steel business. The Company has adopted a strategic business layout of “one base, five elements”, which cultivates synergetic development of businesses of new materials, intelligent service, resources and environment, industrial park and industrial finance based on iron and steel manufacturing business. However, the five- element sectors generate relatively low revenue compared with iron and steel manufacturing business, overlapping businesses among those sectors. Hence, the Company remains largely exposed to the steel business.

Exhibit 2: Steel business as a primary source of revenue (2019) Exhibit 3: China is the largest revenue contributor (2019)

1% 3% 0% Steel Business

14% New Materials 20.4% Intelligent Service 13% Domestic Revenue

4% Resources & Overseas Revenue Environment 82% Industrial Park 79.6%

Industrial Finance

Source: Company, Pengyuan International Source: Company, Pengyuan International

Dominant position in steel market

Baowu is a leader in both the steel market and its subdivisions, such as silicon steel and auto-sheet, ranking the first and the third in the world respectively. We believe the restructuring and acquisition of other steel producing companies in recent years will help Baowu to gain advantage in some other subdivided steel markets. For instance, Magang Group's leading market position in vehicle wheel steels and TISCO’s leading stainless-steel producer status in the world will boost Baowu’s market position in wheel tire, H-shaped steel products and stainless steel in China.

Baowu specialises in producing high quality and high value-added steel products with diversified product lines of carbon steel, special steel and stainless steel for downstream industries, including automobile, household appliance, petrochemical, machine manufacturing industries. The Company has advanced manufacturing technique in modern iron and steel smelting, cold and hot processing, hydraulic sensing, electronic controlling and information technology, helping it to facilitate large-scale

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and automatic manufacturing. With good brand reputation and high quality of product, direct selling contributes to the majority of the Company’s revenue. So far, the Company has established long-term strategic relationship with its customers, most of whom are industry leaders in different manufacturing sectors in China. Financial Profile

Leverage to improve with normalised capital expenditure

We anticipate Baowu’s leverage profile to deteriorate in 2020 due to the economic fallout from the coronavirus pandemic and merger and reorganisation with stainless steel-maker TISCO. The Company’s leverage profile is expected to improve modestly after 2020, thanks to a lower capex and improving industry dynamics. With capacity cut in the Chinese steel industry, Baowu’s capex will be mainly slated for maintenance rather than expansion in both 2021 and 2022. As a result, we expect the Company’s debt to EBITDA to be lowered to 2.5x in 2022 from 3.3x in 2020.

Baowu’s short-term debt exposure is currently 74.6% of its total interest-bearing debt in 2019. However, we consider Baowu’s debt structure risk is contained, as the majority of its short-term debt comes from bank borrowing, which is easier to be rolled over compared to the other market-driven instruments, such as short-term commercial papers or bonds. At the end of 2019, 58% of Baowu’s total short-term debt was related to bank borrowings. In addition, Baowu has ample bank facilities, which offer flexibility to the short-term debt refinancing.

Exhibit 4: A rise of leverage from FY2019 Exhibit 5: Short-term debt dominates its total debt

45% 6.0x 350 in RMB billion 40% 40% 300 5.0x 30% 35% 250 20% 30% 4.0x 200 25% 10% 3.0x 150 20% 0% 15% 2.0x 100 -10% 10% 50 1.0x 5% 0 -20% 0% 0.0x 2017A 2018A 2019A 2020F 2021F 2022F 2016A 2017A 2018A 2019A 2020F 2021F 2022F Short-term debt Long-term debt Gross debt/Capitalization Debt/EBITDA (RHS) Total debt change (RHS)

Source: Company, Pengyuan International estimates Source: Company, Pengyuan International estimates

Profitability to improve driven by revival of China’s economy

Baowu ‘s profitability is expected to remain robust in both 2021 and 2022, with EBITDA margin maintaining at 10-12% driven by improving industry dynamics. While the industry oversupply will continue in the next two years, the demand side is expected to register only a marginal improvement. Overall, China's steel demand is expected to pick up in 2021, in line with China’s economic recovery, with strong government support towards the downstream industries such as construction, infrastructure and automobile.

The Company’s 2020 profit is expected to be lower, caused by weak steel and high iron ore prices. We anticipate Baowu’s EBITDA margin and return on invested capital (ROIC) to drop to 10.5% and 9.2% respectively in 2020 from 10.8% and 12.3% respectively in 2019. During the outbreak of the coronavirus pandemic in China from February to April, the steel price dropped substantially as the demand decreased and inventory level climbed due to transportation restrictions and suspension of work for mining and transportation companies. Despite a recovery in the steel price in the second half of 2020, the iron ore price soared due to disruption in the iron ore supply in Brazil amid the outspread of the coronavirus pandemic. Baowu has a high exposure to the imported ore due to its low self-sufficiency ratio of iron ore.

The profit margin of Baowu has been highly sensitive to market price of steel products and cost of raw materials. Both the EBITDA margin and ROIC of Baowu reached their highs in 2018 thanks to the industry boom, but came off in 2019 due to high cost of iron ore and lower steel price. As a result, Baowu’s adjusted EBITDA declined 29.5% and its EBITDA margin narrowed to 10.8% from 15.9% in 2019.

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Exhibit 6: Revenue and EBITDA fell substantially in FY2019 Exhibit 7: Profitability continues to drop in FY2020

80% 18% 16% 60% 14% 12% 40% 10% 8% 20% 6% 4% 0% 2015A 2016A 2017A 2018A 2019A 2020F 2021F 2022F 2% 0% -20% 2016A 2017A 2018A 2019A 2020F 2021F 2022F

-40% Revenue growth Adjusted EBITDA growth Gross margin Adjusted EBITDA margin ROIC

Source: Company, Pengyuan International estimates Source: Company, Pengyuan International estimates

Government Support

We believe that the central government has a very strong willingness to provide support to Baowu in the event of financial distress. This leads us to closely link the Company’s issuer credit ratings to the central government’s credit profile.

• China’s SASAC directly owns 90% of Baowu’s equity and has control over the board and senior management appointment. As Baowu is strategically vital to the central SASAC, we believe the SASAC has no intention to dilute its ownership and control on Baowu. • There are proven track records of the government’s support to Baowu’s merger and reorganisation through stake transfers approved by the SASAC. We believe the government’s support of mergers and acquisitions will continue in the next three to five years in a bid to strategically enhance industry consolidation. • While Baowu’s products and services are subjected to homogeneous competition and replaceability risk, and its financial contributions to the central government are moderate, the financial and social impacts of default are extremely significant considering Baowu’s leading position in the global steel industry and its key role as economic cornerstone in China.

Liquidity

In our view, Baowu’s overall liquidity risk is low over the next 12 to 24 months mainly credited to abundant bank facilities and positive funds from its operations. As of the end of June 2020, the Company signed total bank facilities of RMB556.1 billion, with unwithdrawn facilities of RMB327.8 billion. The majority of banks with which the Company cooperates are large state- owned banks, policy banks and large-scale joint-stock banks. We believe such bank facilities will stay in place given the Company’s impact on the industry, as well as its strong government backing. We believe that the Company will hold a sufficient cash balance and bank facilities to cover its short-term debt balance over the next 12 to 24 months.

The following key assumptions were made when assessing Baowu’s liquidity:

• Estimated cash and short-term investments of around RMB108 billion and RMB128 billion in FY2020 and FY2021. • Projected funds from operations to be about RMB53 billion and RMB60 billion in FY2020 and FY2021. • Projected net working capital outflows of about RMB38 billion and RMB3 billion in FY2020 and FY2021. • Estimated short-term debt payment of around RMB163billion and RMB187 billion in FY2020 and FY2021 • Estimated cash interest payment of about RMB10 billion and RMB11 billion during FY2020 and FY2021. Company Background

Baowu, headquartered in Shanghai city with multiple production bases all over China, is a world leading steel-maker that manufactures and distributes steel products. The Company was formed by Baosteel Group absorbing its smaller state-owned peer, Wuhan Iron and Steel Corporation in 2016. The Company specialises in producing high value-added steel products with

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a wide range of production lines such as strip steels, steel plates, hot rolled steels, cold rolled steels, steel wires. Baowu conducts new materials, modern trade, industrial finance, and urban service businesses as well. After taking control of Magang Group Holding Co., in FY2019, Baowu’s crude steel production amounted to 95.47 million tonnes and revenue reached USD79.48 billion in FY2019, ranking as the second largest steel-producing company of the world. Peer comparison

Four domestic participants and two international participants were selected based on the consideration of similar operating scale and revenue to conduct a comparison with Baowu. The companies selected are among the global top 10 steel producers. HBIS Group, Jiangsu Shagang Group, Ansteel Group and Shougang Group are among the companies selected within the Chinese domestic market. The two major competitors selected outside China are ArcelorMittal and Nippon Steel Corporation (NSC).

Table 3: Baowu’s peers

HBIS Group Co., Ltd is China’s largest supplier for home appliance steel, second largest for automotive steel and the leading steel supplier HBIS for marine engineering, bridges and construction. With revenue of RMB354.7 billion and total assets of RMB462.1 billion, HBIS has been on the Fortune Global 500 company list for eleven consecutive years and was ranked 214th in 2019.

Jiangsu Shagang Group, whose headquarters is located in Zhangjiagang City, Jiangsu Province, is the largest private steel enterprise and Shagang the biggest electric arc furnace steel production base in China. Shagang Group ranks the 6th in the world’s top 10 steel-makers with a total asset of RMB290 billion, more than 40,000 employees, and an annual steel production capacity of over 40 million tonnes. Ansteel was originated from merger and reorganisation of Anshan Iron and Steel Group Corporation and Pangang Group Co., Ltd in May 2020. As one of the state-owned large-sized enterprises, Ansteel currently has 7 production bases with special characteristics in northeast, Ansteel southwest, north China, southeast and south China. Ansteel has rich iron ore resources in China’s Liaoning and Sichuan and Australia’s Karara. Ansteel is the steel enterprise with the most resource advantages in China. Shougang Group is one of China's largest steel companies and is currently based in Beijing, China. Shougang Group is a state-owned enterprise, with the Government of Beijing holding over a 75% stake. Shougang Group mainly operates in China and Peru in the steel, Shougang mining, machinery, and electronic industries. Shougang Group also conducts minerals, city infrastructure, real estate, and financial businesses. ArcelorMittal S.A. is a Luxembourgish multinational steel manufacturing corporation headquartered in Luxembourg City, with a presence in more than 60 countries and an industrial footprint in 18 countries. It was formed in 2006 from the takeover and merger of Arcelor by Indian- ArcelorMittal owned Mittal Steel. ArcelorMittal is the world's largest steel producer, with an annual crude steel production of 97.31 million tonnes as of 2019. It was ranked 120th in the 2019 Fortune Global 500 list of the world's largest corporations. Nippon Steel Corporation was formed in 2012 by the merger of the old Nippon Steel and Sumitomo Metal. The old Nippon Steel Corporation was established in 1970 by the merger of Fuji Iron & Steel and Yawata Iron & Steel. It operates through the following segments: steelmaking NSC and steel fabrication, engineering and construction, chemicals, new materials, and system solutions. Nippon Steel is the world's third largest steel producer by volume as of 2019 with 51.68 million tonnes crude steel production.

Source: Companies, Pengyuan International The peer comparison table below shows that Baowu’s outperformance versus the average of the samples in terms of leverage profile ratios (debt/EBITDA, EBITDA interest coverage, FFO/debt and gross debt/capitalisation) and profitability ratios (EBITDA margin and ROIC), indicating that Baowu has capacity to balance its leverage and control its cost effectively in such a large production scale. However, Baowu operation efficiency underperforms the average of the samples with longer-than- average receivable days and inventory days, and shorter-than-average payable days. Considering its better than peers’ average financials, Baowu’s credit profile should be in the higher tier among the global steel manufacturing companies.

Table 4: Peer comparison table (with indicators averaged from FY2017-2019) (RMB mn) HBIS Shagang Ansteel Shougang ArcelorMittal NSC Average Baowu Revenues 332,771 136,446 207,001 197,921 484,662 361,461 N/A 494,236 EBITDA 27,164 23,218 26,882 20,093 44,668 32,562 N/A 68,979 FFO 16,177 20,961 17,543 10,647 38,805 37,368 N/A 60,630 Cash and short-term 62,574 28,745 21,608 50,067 28,008 12,369 N/A 93,042 investments Debt 203,516 35,927 147,461 245,437 76,554 136,490 N/A 161,845 Equity 98,180 67,443 106,889 103,544 282,332 205,495 N/A 381,763 Debt/ EBITDA (x) 7.5x 1.6x 5.6x 12.5x 2.4x 4.2x 5.7x 2.4x FFO/Debt 8.0% 62.6% 11.8% 4.4% 52.5% 27.5% 27.8% 37.8% EBITDA interest coverage (x) 1.7x 11.2x 3.5x 1.5x 8.8x 24.0x 8.5x 7.5x Gross Debt/Total 71.5% 46.7% 60.0% 73.2% 24.1% 40.3% 52.6% 36.1% Capitalization EBITDA margin 8.2% 17.1% 13.0% 10.1% 9.2% 9.0% 11.1% 14.1% ROIC 3.9% 26.3% 2.5% 2.7% 6.9% 1.4% 7.3% 11.4% Receivable days 17.4 29.5 37.5 41.0 19.6 48.6 32.3 41.1 Inventory days 38.2 47.2 69.5 84.6 101.4 100.5 73.6 80.9 Payable days 50.1 69.1 84.4 119.6 73.4 95.7 82.1 73.5 Cash conversion cycle 5.4 7.6 22.6 6.0 47.6 53.5 23.8 48.5

Source: Companies, Pengyuan International estimates

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Rating Scores Summary

Business Profile Moderate Industry and Operation Risk Profile Moderate Macroenvironment Risk Low Financial Profile bbb Preliminary Leverage Profile bbb Cash Flow Variations Neutral Debt Structure and Financial Policy Neutral Financial Volatility Neutral Investment Neutral Final Leverage Profile bbb Profitability Medium Indicative Credit Score (ICS) bbb- Adjustment Factors Corporate Structure and Governance Neutral Liquidity Moderate Supplementary Analysis Neutral Standalone Credit Profile (SACP) bbb- External Support Parental Support NA Government Support Very Strong Issuer Credit Rating (ICR) A Note: ratings mentioned in this report are unsolicited rating.

Related Criteria

General Corporate Rating Criteria (15 March 2018)

Government-Related Entities Rating Criteria (31 August 2018)

Financial Adjustments and Ratio Definitions (07 May 2018)

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